Article
Character and Source of Income from
Internet Business Activities
By: Andy Kim, Larissa Neumann, Idan Netser and Jim Fuller
Fenwick & West LLP, Mountain View, CA, http://www.fenwick.com
Introduction
With the increasing interconnectedness of the global economy, the rapid advance of technology,
and the ease with which information and services can move around the world, a clear
understanding of the U.S. tax rules is vital to the long term success of any global technologycentered company. One of the most important issues in the taxation of U.S.-based multinational
companies, particularly those companies that operate primarily in the internet business space, is
the character and source of income.
For internet companies, as well as for other taxpayers,
determining the character of income often involves
trying to distinguish between income from the provision
of services and income from intangible property (e.g.,
royalties). The determination of whether income should
be treated as services income or income from intangible
property will directly impact how such income will be
taxed under the U.S. tax rules, including the application
of the source of income rules. For U.S. companies, the
source of income is particularly important in
determining the extent to which a foreign tax credit can
be claimed.1 For foreign companies and for U.S.
companies making payments to foreign companies, the source of income is important to
determine whether certain income may be subject to U.S. withholding taxes or taxed as income
that is effectively connected with a U.S. trade or business.2
1
2
Section 904(a) of the Internal Revenue Code (the “Code”) operates to limit a taxpayer’s foreign tax
credit to the amount of U.S. tax imposed against the taxpayer’s foreign source taxable income. Due
to the mechanics of the § 904 foreign tax credit limitation, U.S.-based taxpayers prefer receiving
income that is characterized as foreign source income.
Non-U.S. persons generally are subject to U.S. taxation on U.S. source income that is considered
fixed or determinable annual or periodical gains, profits, and income (e.g., interest, dividends, rents,
royalties). §§ 871(a) and 881. Typically, taxation takes the form of a U.S. withholding tax. Thus,
the U.S. payor of this income to a foreign person can become a withholding agent, with liability for a
failure to withhold. Alternatively, a non-U.S. person’s U.S.-source income, such as U.S.-source
services income, could constitute effectively connected income. §§ 871(b) and 882. Non-U.S.
persons generally are not subject to U.S. taxation on foreign source income unless the income is
considered effectively connected with the conduct of a U.S. trade or business. §§ 871(b) and 882.
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Character of Internet-Related Income: Services Income or Royalties?
The rapid growth of internet-related businesses such as online advertising, cloud computing, data
warehousing, and internet hosting, adds further significance to the question whether income
generated from these activities should be treated as services income or income from the use of
intangibles.3 Among other significant consequences, the characterization of income as services
income or royalty income may affect a company’s ability to maximize its foreign tax credits, the
amount of income to be immediately taxed under Subpart F of the Code, withholding tax rates,
and the application of the § 482 transfer pricing rules.
Traditionally, the distinction between services income and income from the use of intangible
property has hinged on whether the owner and the user of the intangible property are the same
person. Income derived from permitting another person to use property with a share of the
profits reserved by the owner generally results in royalty or rental income.4 In contrast, property
used in connection with the provision of services is considered to be owned and used by the
service provider, not the service recipient. The service provider may use its intangible assets in
rendering the services, but keeps the assets.
Note, however, that if assets are produced from the rendering of the services, the service provider
typically will not own the newly created assets. In this regard, the rendition of services usually
involves the employment of capital and labor for the benefit of another, without the retention by
the service provider of ownership rights or interests in the fruits of the services.5 R&D type
services, for example, where it is the service recipient (not the service provider) that obtains
3
4
5
10
For this purpose, intangibles generally includes patents, copyrights, secret processes and formulas,
goodwill, trademarks, trade names, franchises and other like property. §§ 861(a)(4), 862(a)(4).
See, e.g., Commissioner v. Wodehouse, 337 U.S. 369 (1949) (amounts received by the taxpayer for an
exclusive copyright to the American market for stories to be written were royalties); Rev. Rul. 74555, 1974-2 C.B. 202 (payments received by the taxpayer for the use of, or for the privilege of using,
copyrights in the U.S. are royalties, and not compensation for labor or personal services, because the
taxpayer did not give away control over what the taxpayer was to write or when it was to be written,
but merely the right to publish the books or stories that were written.).
Boulez v. Commissioner, 83 T.C. 584 (1984) (payments received by taxpayer for conducting an
orchestra were payments for the performance of personal services because taxpayer has no property
interest in the fruits of his work, i.e., the recordings). Boulez highlights some of the problems in this
area. Germany said the taxpayer received royalty income; the U.S. said the income he received was
services income. He was taxed in both countries. The taxpayer unsuccessfully sought competent
authority relief, but the countries’ competent authorities couldn’t agree. Thus, the taxpayer was
forced to litigate, and lost again. Part of the taxpayer’s problem was that his contract wasn’t
sufficiently clear as to the nature of his income. Cf. Goosen v. Commissioner, 136 T.C. No. 27
(2011) (“The characterization of petitioner’s on-course endorsement fees and bonuses [as services
income or royalties] depends on whether the sponsors primarily paid for petitioner’s services, for the
use of petitioner’s name and likeness, or for both. We must divine the intent of the sponsors and of
petitioner from the entire record, including the terms of the specific endorsement agreement.”).
The Contemporary Tax Journal
ownership of the intellectual property that is developed,6 are more in the nature of building
(developing) property for the service recipient, and thus constitutes the rendition of services.7
In determining whether income from internet related activities should be characterized as
services income or income from the license of intangible property, it is helpful to consider
§ 7701(e), which sets forth a list of factors to consider in distinguishing between service
contracts and leases. Section 7701(e), although enacted to provide guidance on the availability
of certain investments credits, generally applies for all purposes of the income tax provisions of
the Code.8 A services contract can be treated as a lease if certain requirements are met.
Under § 7701(e)(1), factors indicating the existence of a lease (rather than a services contract)
include: (A) the service recipient is in physical possession of the property, (B) the service
recipient controls the property, (C) the service recipient has a significant economic or possessory
interest in the property, (D) the service provider does not bear any risk of substantially
diminished receipts or substantially increased expenditures if there is nonperformance under the
contract, (E) the service provider does not use the property concurrently to provide significant
services to entities unrelated to the service recipient, and (F) the total contract price does not
substantially exceed the rental value of the property for the contract period.
Applying these principles to internet related activities, it seems that income from activities such
as cloud computing, data warehousing, database access, web-hosting transactions, and the like
should be treated as income from services transactions rather than from the use of intangible
property. In all of these activities, the operating company providing the service typically owns,
controls, operates, and maintains the equipment on which the data or web site is stored. The
operator provides customers with access to the equipment and software and the operator has the
right to remove and replace equipment and software at will. Customers typically will not have
possession of, control over, or any interest in, the equipment and software used. Moreover,
customers use the equipment and software concurrently with other customers and pay a volume
or time-based fee.
6
7
8
See, e.g., Karrer v. United States, 138 Ct. Cl. 385 (1957) (taxpayer's compensation for products
developed as a result of the taxpayer's research is compensation for personal services and not
royalties because the taxpayer did not own any intellectual property rights in developed products).
In 1998, the Treasury promulgated Treas. Reg. § 1.861-18 in an attempt to deal with the
characterization of income from software transactions involving computer programs as royalty or
sales income. See T.D. 8785, 1998-2 C.B. 496. The key question in this regulation is whether
substantially all the rights in the copyright, including the right to freely distribute the copyright, are
transferred. The right to freely distribute the article resembles complete control and ownership of the
article. If substantially all the rights are transferred, the transaction is a sale. However, Treas. Reg.
§ 1.861-18 generally does not distinguish between services, royalty, and sales income, since the only
services that are covered by the regulation are software programming related services. See Treas.
Reg. § 1.861-18(b).
See JCT Explanation of the Deficit Reduction Act of 1984, JCS-41-84, at 59. Section 7701(e)(1)
reversed a prior case which the government had lost: Xerox Corp. v. United States, 656 F.2d 659
(Ct. Cl. 1981).
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The Organization for Economic Co-operation and Development (the “OECD”) also regards
income from such activities as services income.9 The same conclusion can be reached with
respect to targeted online advertising. Although targeted online advertising entails the use of
intangible property (e.g., search and matching algorithms, and valuable end-user data), the
proper treatment of this income should be services income. A company that provides online
internet advertising provides valuable sophisticated advertising services that allow advertisers to
reach a particular audience. In this regard, an advertising customer generally pays for the
dissemination of advertisements to particular users of a given web site, rather than for the
customer’s use of end-user data.
In the seminal case of Piedras Negras Broadcasting Co. v. Commissioner, 43 B.T.A. 297 (1941),
nonacq., 1941-1 C.B. 18, aff’d, 127 F.2d 260 (5th Cir. 1942), the court found that the situs of the
taxpayer’s advertising activities were at the location of its broadcasting facilities in Mexico.
Although the court did not have to rule on the character of the income (since both rental income
and services income would have been sourced in Mexico), both the Board of Tax Appeals and
the Fifth Circuit looked to the broadcasting equipment (i.e., capital) and efforts (i.e., labor) for
the determination of the situs of the taxpayer’s income producing activities.
The court’s focus on the location of the broadcasting equipment and labor indicate that these
activities should be characterized as services.10 The location of the broadcaster’s audience
(largely in the U.S.) was not a relevant consideration even though advertisers paid for access to
that audience. The Fifth Circuit stated that “all services required of the taxpayer under the
contracts were rendered in Mexico.”11 Certain incidental activities in the U.S. – employees
crossing the border to collect mail and meet with advertisers to get paid – and the solicitation of
business in the U.S. by dependent (an employee) and independent agents did not change this
conclusion since the compensation under the contracts was for the services performed in Mexico.
The Service’s holding in PLR 6203055590A (Mar. 05, 1962) provides further support for this
conclusion. In PLR 6203055590A, the taxpayer sold advertising to U.S. advertisers for
publication in a magazine to be distributed only outside of the United States. For purposes of
determining the source of the taxpayer's advertising income, the Service only considered the
sourcing rules under §§ 861 and 862 for compensation for labor or personal services. The
Service characterized the payments to the taxpayer as “remuneration for its activities in
disseminating their advertisements in its magazine published and distributed outside the United
States.” According to the Service, the “source of the advertising revenue to be received by [the
taxpayer] from the U.S. advertisers, is the capital and labor employed in the publishing and
distributing centers [outside the United States] with and through them, [the taxpayer] will carry
on the activities to produce the advertising revenue.” In other words, the taxpayer employed
capital and labor for advertising, resulting in income from services.
9
10
11
12
See Report to Working Party No. 1 of the OECD Committee on Fiscal Affairs by the Technical
Advisory Group on Treaty Characterization of Electronic Commerce Payments (February 1, 2001)
(the “OECD Report”).
See also Korfund Co. v. Commissioner, 1 T.C. 1180, 1187 (1943) (“The Piedras Negras
Broadcasting Co. case . . . involved employment of capital and labor in a foreign country in
connection with the rendition of service . . . .”).
127 F.2d at 260.
The Contemporary Tax Journal
The OECD also regards income from online advertising activities as services income. As stated
in the OECD Report, “All members of the Group agreed that the payments arising from
[advertising] would constitute business profits falling under Article 7 [i.e., business profits]
rather than royalties, even under alternative definitions of royalties that cover payments ‘for the
use, or the right to use, industrial, commercial or scientific equipment.’”12
Sourcing of Internet Services Income
In today’s internet-driven business space, activities such as online advertising, cloud computing,
data storage, internet hosting, and customer support often can cross multiple national boundaries
and pose a challenge to the application of traditional sourcing rules. As discussed above, the
income derived from the activities generally should be treated as income from services, rather
than income from intangible property.13
General Sourcing Rule.
The general rule is that the source of income for services is the place of performance of those
services. §§ 861(a)(3) and 862(a)(3). Traditionally, services have been performed by
individuals located at easily identified physical locations. However, as services today
increasingly involve multiple activities, personnel, locations, and technologies, determining the
place of performance of services has become more challenging. Even with these added
complexities, the basic source of income rules for services are still instructive in planning for
today’s more complex business transactions.
The Piedras Negras case provides useful guidance in determining the source of income for high
tech companies. As discussed above, the Piedras Negras case involved a foreign radio station
located close to the U.S. border that broadcasted programming targeted primarily at U.S.
listeners. The majority of the foreign radio station’s income was derived from U.S. advertisers.
The studio and broadcasting plant were located in a foreign country (Mexico) and the
employment of capital and labor was outside of the U.S. The Fifth Circuit stated that the source
of income “is the situs of the income-producing service,” that is, the “services required of the
taxpayer under the contracts.”14 Under these facts, the court held that there was no U.S. source
income because the principal place of business was outside the U.S. and the labor and activities
that produced the income were outside the U.S.
Piedras Negras continues to be relevant to high tech companies today because it addresses issues
that arise when a multinational corporation provides complex services in multiple locations.
Importantly, the case held that the location of the customer is not relevant in determining the
source of income. Just recently, the Fifth Circuit in Container Corporation v. Commissioner,
2011 U.S. App. LEXIS 8961, at *4, 107 AFTR 2d 2011-1831 (May 2, 2011), cited the Piedras
Negras case in determining the source of income for guaranty fees and stated that “[i]t is clear
12
13
14
OECD Report, supra note 9, at 28.
Section 861 sets forth significantly different source rules for services income from those from royalty
income. Cf. §§ 861(a)(3) and 861(a)(4). Whereas the source of services income is generally the
place of performance of the services (§§ 861(a)(3), 862(a)(3)), income from the use of intangibles,
such as royalty income, is generally sourced to the place where the licensee uses or is entitled to use
the property (§§ 861(a)(4), 862(a)(4)).
127 F.2d at 260-61.
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that the source of payments for services is where the services are performed, not where the
benefit is inured.”
Many internet companies, like search engines and social networking sites, earn a significant
portion of their revenue from online advertisements. An interesting issue with advertisements is
that the ad content is usually created by third party advertisers. Advertisers pay for access to
potential customers, and they are willing to pay more money if they can be assured that an ad
will reach either a large number of people or a selected target audience. To determine the situs
of the income producing activity, the IRS or a court generally would apply a facts and
circumstances test.
While the location of the servers could be one factor the IRS or a court would consider, the
server location alone should not be a determinative factor for sourcing advertising income.
Servers often can be located in different locations and are not necessarily the situs of the income
producing activity. Server capacity also can be obtained from third parties and can be viewed as
a commodity service that arguably does not add a significant amount of relative value. Further,
server utilization can switch from one server to another based on capacity, possibly involving
servers in different countries. Although one might equate servers to the broadcasting equipment
used in the Piedras Negras case, the location of the broadcasting equipment was only one factor
that was considered in the court’s analysis.
An OECD discussion paper states that in the context of stand-alone computer servers, the
functional and factual analysis is likely to show that the server is “performing only routine
functions and is reliant on other parts of the enterprise to provide the intangible assets necessary
for it to perform most, if not all, of those functions.”15 Accordingly, the OECD Paper states the
activities of the servers are very unlikely to warrant being attributed a substantial share of the
profit. The OECD Paper also notes that where personnel are present “to perform maintenance
and online services tasks, the quantum of the profit attributable to the permanent establishment
would be commensurate with what independent service providers would be expected to earn in a
similar situation.”16
Since source of income is determined according to the location where the income producing
activity occurs (i.e., the location of the services required under the contract), the location of the
employees that provide the service and the property used in the service are relevant. If all of a
company’s employees and property are located in a foreign country, it normally should be easy
to conclude that the source of compensation for services should be outside the U.S. However,
additional questions can arise when contributions to the service are provided by third parties.
Contributions to Services from Third Parties.
Complexities can arise when a service provider contracts with related and unrelated parties to
perform some or all of the activities necessary to provide the service. Since multinational
corporations contract with various related and unrelated entities in various locations, taxpayers
should be mindful of situations in which the activities of certain agents could be attributed to the
principal for purposes of applying the source of income rules.
15
16
14
Attribution of Profit to a Permanent Establishment Involved in Electronic Commerce Transaction,
OECD, at 4 (February 2001) (“OECD Paper”). See also Report on the Attribution of Profits to
Permanent Establishments, OECD (December 2006).
OECD Paper, supra note 15, at 4-5.
The Contemporary Tax Journal
If a dependent agent conducts activities in the U.S. on behalf of the principal, income earned by
the principal but which is generated in part by that agent’s activities could be deemed U.S.
source income to that extent. Conversely, if a dependent agent is located in a foreign
jurisdiction, then the income potentially could be classified as foreign source services income.
However, the activities of independent agents and entities otherwise dealing with the principal at
arm’s length generally should not be attributable to the principal and should not affect the source
of the income. Further, the fact that a parent and its subsidiary, or two subsidiaries, contract with
each other for the provision of services should not automatically create a relationship that would
affect the source of income.
In Miller v. Commissioner, 73 T.C.M. (CCH) 2319 (1997), aff’d, 166 F.3d 1218 (9th Cir. 1998),
the Tax Court held, and the Ninth Circuit affirmed, that services performed by a subsidiary did
not create U.S. source income for the foreign parent company in that the relationship between the
subsidiary and the parent was essentially no different from that of an unrelated independent
contractor. In Miller, a foreign corporation was paid by U.S. entities to perform research and
development. The foreign corporation subcontracted all of the research and development work
to certain related and unrelated entities, including its wholly owned U.S. subsidiary. Since the
foreign corporation did not itself perform services in the United States, the court held that there
could not be any U.S. source income attributable to the foreign corporation.
In reaching its conclusion in Miller, the court found that there was no evidence requiring the
court to disregard the corporate form of the U.S. entity. The court treated all transactions
between the parent and the subsidiary as being conducted at arm’s length. Even though the U.S.
company was a wholly-owned subsidiary of the foreign corporation, it was doing business under
its own name as a separate distinct entity and thus the activities of the U.S. subsidiary did not
cause the foreign parent corporation to have U.S. source services income.17 The court stated that
in order for the foreign parent corporation to be considered as having U.S. source income by
virtue of the performance of services, the foreign corporation itself would have to perform the
services through agents or employees of its own. Even here, however, the relevant services
should be limited to those services that are required of the taxpayer under the contract, as noted
by the Fifth Circuit in Piedras Negras.
Based on the principles established in Miller, a subsidiary’s
provision of services should not be attributed to a different
entity in the group in determining the source of that entity’s
services income provided that the corporate identity of the
subsidiary is respected, the activities are conducted on an
arm’s length basis, and the relationship is no different from
that of unrelated independent contractors. Both entities
17
73 T.C.M. (CCH) at 2323 (“The fact that a lower tier corporation performs some services in the
United States is insufficient to support a conclusion that its higher tier parent corporation also
performs services in the United States. The two corporations are and should be treated as separate
persons unless one corporate form is a sham.”).
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should have real operations and exercise a measure of autonomy.18
The Supreme Court in Commissioner v. Bollinger, 485 U.S. 340 (1988), established a clear
bright line test for when the tax consequences of property held by an agent will be attributed to a
principal. This same test could be useful in identifying situations in which the activities of a
genuine agent may be attributed to a principal for income sourcing purposes. In Bollinger, the
Court held that losses generated by apartment complexes that were registered in the name of
certain corporations were attributable to the principal because the corporations owned the
apartment complexes merely as agents of the principal. The Court held that the activities (in this
case, ownership of the apartment complexes) of one corporation should be attributed to another:
(1) when the fact that the corporation is acting as an agent is set forth in a written agreement,
(2) the corporation functions as an agent and not a principal, and (3) the corporation is held out
as an agent to third parties.
The Court reconciled its holding in Bollinger with an earlier case, National Carbide Corp. v.
Commissioner, 336 U.S. 422 (1949),19 stating that the parent’s control over its subsidiaries does
not establish the existence of an agency relationship and that agreements to pay the parent all
profits above a nominal amount are not determinative since income must be taxed to those who
actually earn it without regard to assignment.20
18
19
20
16
The Supreme Court has maintained that the corporate entity doctrine serves a useful purpose in
business life, and that a corporation will remain a separate taxable entity as long as the corporation
carries on a business purpose. In Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943), the
Supreme Court held that a corporation is a separate entity and not an agent of its stockholders.
However, the Court noted that the corporate form may be disregarded when it is a mere sham or
unreal. In Moline Properties the Supreme Court held that there was neither an agency contract, nor
the usual incidents of an agency relationship, and that the mere existence of a corporation with one or
several stockholders did not make the corporation the agent of its stockholders.
The Court in National Carbide held that certain subsidiary corporations were not acting as genuine
agents of the parent corporation, and therefore the subsidiaries were required to recognize the full
income earned from their respective operations (rather than treating the income as directly belonging
to the parent corporation).
The Second Circuit in Le Beau Tours Inter-America, Inc. v. United States, 547 F.2d 9 (2nd Cir.
1976), aff’g 415 F. Supp. 48 (S.D.N.Y. 1976), attributed the activities of a parent corporation to its
subsidiary for purposes of determining the source of the subsidiary’s services income. This decision
is of questionable validity. The taxpayer in Le Beau Tours organized vacations in Latin America for
U.S. tourists and claimed that all of its income was from foreign sources because it received its
income by making these arrangements in foreign countries for oversea travelers. The U.S. parent
corporation performed activities in the U.S. such as advertising and other administrative functions.
The taxpayer asserted that its activities only generated foreign source income because the activities
performed by the U.S. parent generated U.S. source income only for the U.S. parent. The court
recognized that a corporation may divide its business by forming a separate subsidiary. However, the
court stated that the U.S. corporation was created for the sole benefit of the Latin America operations.
The Second Circuit’s decision in Le Beau Tours cannot easily be reconciled with the Supreme Court’s
decisions in Moline Properties and Bollinger. Based on the Supreme Court’s decision in Moline
Properties, the court in Le Beau Tours should have treated the U.S. corporation as a separate distinct
entity unless it was a sham operation. According to Bollinger, decided after Le Beau Tours, the court
in Le Beau Tours should not have disregarded the separate corporate entity for tax purposes unless the
corporation was an agent and held itself out as an agent to third parties. Miller, also, is contrary to Le
Beau Tours.
The Contemporary Tax Journal
Although issued prior to Bollinger, a technical advice memorandum issued by the Service also is
relevant. With facts very similar to those in Piedras Negras, the Service held in TAM 8147001
(Jan. 3, 1979), that no agency relationship existed between a foreign corporation, which owned a
radio station in a foreign country, and its owner, a U.S. corporation. The U.S. corporation was
not the foreign corporation’s exclusive agent and the foreign corporation did not exercise any
control over the U.S. corporation’s activities. Further, the foreign corporation did not require
that the U.S. corporation only sell radio time on behalf of the foreign corporation’s radio station.
Based on these facts, the Service concluded that the source of income was from sources outside
the U.S.
In light of this authority, multinational internet businesses should be mindful of how they
contract with related and unrelated parties to provide any activities that are necessary to generate
the principal’s profits. The characterization of agency relationships, the corporate form, and the
agreements are critical to effective international tax planning generally, and the sourcing of
income in particular.
Conclusion
The character and source of income are important components of any multinational tax planning
effort. However, identifying the proper character and source of income for companies that
operate in today’s high tech business environment, including internet-related businesses, can be
especially important given the ease with which technology and services seemingly can cross
national boundaries.
To minimize the likelihood of disputes with both U.S. and foreign tax authorities concerning the
character and sourcing of services income, taxpayers are well-advised to clearly specify not only
the scope of any rights that are being provided (or not provided) as part of the services, but also
the location(s) in which the services are to be performed. Provided that the contract terms
reasonably reflect the actual rights and services being provided, having such contract terms in
place may go a long way towards avoiding unnecessary surprises and disputes concerning the tax
treatment of services income.21
About the authors
Andy Kim and Jim Fuller are partners, and Larissa Neumann and Idan Netser are associates in
the Mountain View office of Fenwick & West, LLP. Jim Fuller is also a member of the San José
State University MST Program's Tax Advisory Board and a frequent speaker at the TEI-SJSU
High Tech Tax Institute. For more information about the authors and Fenwick & West, visit
http://www.fenwick.com.
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21
Cf. Goosen v. Commissioner, 136 T.C. No. 27 (2011) (“The contracting parties to the transaction have
the burden of making a reasonable allocation of the royalty income between the U.S. and foreign
sources.).
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